The Calm Before

“Once you’ve accepted your flaws, no one can use them against you.” – Tyrion Lannister in George R.R. Martin’s A Song of Ice and Fire

Stocks may been off a bit last week, but were still up on the month. The odd part is that the gains on the month could be traced almost entirely to the fact that the last-day-of-May sell-off wasn’t as bad the much harsher one on the last day of April: the S&P 500 was up 0.03% between April 29 (the next-to-last day of April) and May 29, the last day of May. Or in other words, unchanged. Perhaps more worthy of note is that the S&P hasn’t closed a month on an up note since last October. For me, that is another telling sign of a fading market cycle.

There is certainly plenty of fodder for conversation out of last week – the usual obsessions with central bank policy that focus above all on what the Fed’s timetable might or might not be; the latest episode in the Greek drama, which may prove to be the worst one in the end, though far from the scariest so far as the market is concerned. The latest GDP revision for the first quarter (see details below) to (-0.7%) prompted more hand wringing and some statistical calling out of the Bureau of Economic Analysis (BEA), which seems to have missed a consistent downside bias to its first-quarter seasonal adjustments. And let’s not forget China, whose machinations to bail out a failing economy are going to end up adding misery to the final bill, when overextended equity markets crash even harder – but until then, more stimulus means higher prices, right?

The real issue isn’t the Fed’s decision to wait until September or December, but that the business cycle is ending. Not this month, not this quarter, but it is coming and not a couple of years away, either. For all the talk about whether or not first-quarter GDP is underestimated, the earnings growth rate for the S&P 500 was 0.7% with six companies left to go, according to FactSet. That’s the weakest growth in ten quarters, and the comparative decline in revenue (-2.9%) was the poorest showing since 2009. Based on current estimates for a 1.7% earnings gain for all of 2015 and the tendency for analysts to backload earnings gains into the fourth quarter, as well as forward estimate cuts into the end of the preceding quarter, I currently expect the S&P 500 to have an earnings decline for all of 2015. Meantime, its valuation is in the top 2% on a historical basis. Yes inflation is low, yes the Fed is supportive, yes you can’t earn much on bonds. When business cycles end, valuations return to the ground regardless of all of the good excuses.

June is traditionally a difficult month for stocks, with the classic pattern being a sharp fade in the early part of the month followed by a rebound in the back half. This year’s edition is up for grabs. A good resolution for Greece would be a tailwind for stock prices, a bad resolution would mean a headwind and the usual in-between outcome of kicking the can down the road could mean a rally of one or two days followed by a return to reality. The Federal Reserve meets in the middle of the month (16th-17th), followed by quadruple witching two days later. That is good fuel for more volatility, and could lead to some serious whipsaw action in the markets.

On balance, stocks will keep trying to grind higher into the fall, but the odds favor a few moments, if not days, between now and then when the indices will be back in the red on the year (though perhaps not this cycle’s last hiding place, the Nasdaq). Those episodes are likely to be followed by periods of in-your-face short squeezes and rallies, all very typical late-cycle behavior, that are likely to push prices back to new highs and perhaps convince the majority that things will be better next year. That is, until that particular trade doesn’t work anymore. Markets are likely to be flat overall for the summer, but I would not add money to this market.

The Economic Beat

With the stock market’s volatility last week, it isn’t easy to say what the report of the week was, nor is it easy in purely informational terms. I’ll call it a tie between the durable goods report (Tuesday) and Friday’s latest revision to first-quarter GDP.

The BEA reported in its second estimate of first quarter GDP that the latter shrank at an annualized rate of (-0.7%), a tenth better than the lowered consensus. A steady drumbeat of complaints about the potential accuracy of the numbers began last week, in particular about an apparent bias towards lower seasonally adjusted rates in the first quarter of the year. On Friday afternoon, the tempting tagline that first quarter GDP is chronically better than reported was being repeated on practically every news outlet you could find. I half-expected a raven from Tyrion Lannister to arrive bearing the same message.

The excuses flowed in from all over. It’s a familiar litany by now – winter held down spending, the strong dollar and the port strike combined to upset the trade balance, transitory this, transitory that.

The headline numbers are indeed seasonally adjusted and annualized, so any persistent bulge does need to be examined, and I am hardly the one to leap to the defense of the sanctity of GDP estimates. However, the BEA is not about to pull some rabbit out of its hat that can show that we’re all really much better off. If it adds additional weight to the first quarter seasonal factors, those weights should come out of some other quarter. The annual numbers shouldn’t change, nor the trend: the current 3-year average of nominal (not inflation-adjusted) GDP is 3.84%. One year ago, it was 3.82%. The last ten consecutive quarters have been between 3.8% and 4%.

As I wrote some time ago, we should see rebounds in the second and third quarter, but they will not be as good as the second and third quarters of last year, mainly because this year’s first quarter dip wasn’t as deep. The business press is always in a hurry to highlight the transitory factors making for subdued activity, but rarely acknowledge the transitory nature of rebound activity. Last year we had no significant hurricane or tropical storm damage, a fine tailwind for the rebound from the first quarter. This year, who knows? Perhaps the incipient El Nino system will mean that the West Coast gets pounded by storms, or it may fizzle out. All we can say for sure is that there is always weather.

The GDP benchmarks are set to be revised and a new set of numbers is due at the end of July. However, a linear transformation of the numbers – adding fifty basis points a quarter, for example, for newly found factors – isn’t going to change anyone’s well-being, nor is it going to change profits or earnings.

Durable goods orders can’t be explained away by seasonal factors. The fact is that on an non-adjusted basis, the first four months of 2015 are running below the first four months of 2014 – the period of the lowly (-2.1%) first quarter. Even easy comparisons couldn’t produce any improvement. Lower energy prices are playing a big role in the lower order rates, but other businesses aren’t taking advantage of lower energy prices to invest in anything but their stock price. New orders in April were down 0.1% seasonally adjusted, and up 0.5% excluding transportation. But they are also down 0.7% for the first four months when excluding transportation. Apart from energy, business cap-ex spending has been anemic throughout this cycle, and will remain that way until not investing in cap-ex becomes too punitive. With profit growth easing towards negative, it could be a long wait.

Manufacturing is not contracting at the moment, not nationally, but overall the sector is also struggling to find growth. The regional surveys have been very much like the latest read from the Richmond Fed district, which reported a result of 1 in its latest survey (zero is neutral). Yet while energy-related districts have been in contraction for some time, the drop in the Chicago purchasing index all the way down to 46.2 (neutral=50) was quite a surprise. The region’s fortunes have been closely tied to auto sales, which have been roughly flat to slightly down for the last few months; May auto sales will be released on Tuesday.

Housing is a mixed bag. Much attention went to the pending home sales index, which the National Association of Realtors informed us to be at a 9-year high. But while pending home sales were up 3.4% this month and 14% over the last year, existing home sales are up only 6% and were down last month. New-home sales appear to be faring better, with a big bounce to a still-low annualized rate of 517K, but I am skeptical that the increase will hold up. I may be wrong of course, but the series is prone to large revisions and big surprises usually disappear with the next release. All of that said, real estate typically peaks near the ends of business cycles and so I expect housing to remain in a mild uptrend for the near future.

Corporate profits in the first quarter, as reported by the BEA, were up only 2.7%, in the first quarter and even that number is at risk, as Q4 2014 was revised downward from +2.9% to (-2.5%)! As this chart from Econoday makes plain, yearly profit growth is steadily fading towards the zero line.

Next week will be an important one, highlighted by the ECB meeting on Thursday, the jobs report on Friday, and whatever happens in the very public game of bluff and counterbluff between the various actors in the Greek liquidity drama. Regarding the latter, it’s pretty easy (and perhaps correct) to presume another last-minute swerve from disaster, but I have a rule: never bet on policy decisions. I don’t believe a “Grexit” would necessarily be immediate disaster for the financial markets, rather more an event whose ultimate ramifications would take many months to play out. It’s the kind of event where people in the moment say, “see, it wasn’t so bad” after the markets fail to react in any dramatic way, and then two years later gets blamed for being a recession catalyst.

Other reports next week include personal income and spending on Monday, along with the ISM manufacturing survey and April construction spending. The non-manufacturing ISM report is on Wednesday, following factory orders (signaled by durable goods) are on Tuesday and international trade earlier that morning. The Fed’s Beige Book is due Wednesday morning, and might make for some interesting reading.